While it's not the most glamorous thing in the world, all businesses - particularly large scale enterprises - need efficient service operations.

What if an employee's computer won't boot up? What if someone needs a new monitor? What if an associate requires access to a software system? These are just a very small subset of potential IT-related problems employees face every day. Reporting, tracking, managing, and resolving these requests can be a complex process that frequently frustrates both employee ("why is this taking so long?!") and IT manager ("don't they know the process for reporting these?!").

Of course, IT is just one - albeit the most prevalent - department where service requests are routed. Human Resources departments have to manage employee requests and questions every day, as well: "How do I change my tax withholding?"... "There was an error in my paycheck!"... "Where do I go to check my 401(k)?"... and so forth.

Similar service management is needed for customers, too. Requests come in daily for warranty issues, product information requests, billing info updates, etc.

Historically to solve these issues, enterprises have come up with all kinds of systems, most of them specific to certain areas with little to no integration into a single whole. For example, to request new hardware, you may have had to use one system, vs. a completely different system to request software access permissions. Not only is the frustrating and confusing for users, but it saps productivity and efficiency from organizations as a whole.

Over the past decade, one company has stepped into this void and made a huge impact. Let's take a closer look at ServiceNow (NOW).

Revamping Corporate Service Processes

ServiceNow offers enterprises an integrated, cloud-delivered platform-as-a-service (PaaS) that allow them to design service processes from a top-down perspective, integrating a lot of formerly separated tasks.

The company's software was initially focused on IT. ServiceNow offers a consumer-like help desk experience, allowing requesters to easily request new services, report problems, and incidents, etc. On the back-end, it performs automated categorization of requests, routing to the appropriate department, and assignment of work to facilitate a faster solution.

This is the best of both worlds. It offers the employee with a problem a one-stop place to go to report that problem, while also automatically handling the management work of finding the right department and people to solve the issue.

The platform can do a lot of other things, as well. For example, ServiceNow provides asset and cost management, allowing a firm to catalog EVERY IT asset (computer, laptop, monitor, server, etc.) it owns, monitoring the health, current configuration, and update status of said asset. It also provides a wealth of dashboard and reporting tools for high-level views of service organization performance, as well as software APIs for companies to develop their own applications off of the ServiceNow platform.

IT continues to be ServiceNow's bread-and-butter, accounting for about 2/3rds (66%) of revenues. But the firm has also seen much success pushing its platform into other departments of the enterprise. Three departments in particular - Human Resources, Security, and Customer Service - are natural service-heavy organizations to expand into. These three areas - lumped into "Emerging Products" - already account for close to 30% of revenues.

The Business Model

In general, there are 3 business model characteristics that identify excellent, long-term investment opportunities. So how does ServiceNow stack up on each one?

1. Are Revenues Structurally Recurring? - The answer to this is a resounding "yes!". ServiceNow uses the typical cloud software subscription model, where customers pay over recurring duration periods. 92% of sales are from this recurring model. The average contract duration for new customers is about 3 years, and renewals are generally about 2 years.
2. Can Revenues Grow At A Strong Pace (over 10%) For At Least 5 Years? - Again, the answer has to be "yes". ServiceNow has a 3-year compound annual revenue growth rate over 35%, and recent sales growth continues at a similar pace. While the company has grown rapidly and is now quite large (over $30 billion market cap), there is still ample room for growth. Forbes Global 2000 penetration is still modest at just 42%, and ServiceNow continues to increase its client count by about 10% per year. Upsells have been the real growth driver, with existing customers adding more services every year - 3/4ths of clients now subscribe to more than one service (up from under 30% a few years ago). ServiceNow should be able to continue adding new customers, new services (it ranks #1 on Forbes Most Innovative Companies list), and gradually raising prices to continue its growth trajectory. Management estimates an enormous $60 billion addressable market!
3. Does The Company Have Durable Competitive Advantages (e.g. a moat)? - One of the most attractive things about an investment in enterprise process software are the extremely HIGH SWITCHING COSTS that come with it. Service offerings affect everyone in an organization, and getting a large employee base trained and used to using them is expensive and time-consuming. After so much investment, large companies are loathe to change because of the high costs. One statistic captures this effect for ServiceNow - 98% of customers renew their contracts! That's remarkable.

So there you have it. A growing recurring revenue base combined with very high switching costs for existing customers makes for a fantastic business model. Its cash flows are highly predictable, allowing management to aggressively invest for growth, and protecting the firm against economic swings. ServiceNow has outstanding business characteristics.

The Financial Picture

Many numbers-oriented investors will naturally ask: "What about the profits?"

Well, to be frank, there are none. ServiceNow has been GAAP unprofitable for virtually its entire history as a public company and remains so to this day.

That can't be good, right?

In fact, I'm not too concerned with it. Far more important are cash flows, and here ServiceNow comes out in good shape, with nearly $600 million in free cash flow over the past 12 months, a 25% margin on revenues. In fact, the firm has been free cash flow positive for the last 5 years. This is because it must recognize subscription contract payments as revenue rated over the contract duration, but it receives the cash up front. This phenomenon can be seen on the deferred revenue line, where deferred revenues have grown from $252 million in 2013 to an impressive $1.3 billion today. From a cash perspective, ServiceNow is quite profitable already.

Also, most of the firm's operating costs are marketing - almost 50% of revenues. This makes sense given the huge addressable market and emerging competition in the space. Given the high switching costs, once a client is on board, management is in a "land grab" scenario, where it is spending now to grab (and keep) customers while there is opportunity to. Over time, I expect marketing to ease down to a more industry standard 15-20% rate.

As for the balance sheet, it looks fine. There is nearly $2 billion in cash and equivalents vs. $860 million in debt, and current ratio is in very safe territory at about 1.3. Remember, this is a very predictable business, so it makes sense for management to aggressively finance growth at this stage.

Competition

ServiceNow's main competition from a "full-suite", cloud-based perspective is probably Microsoft's (MSFT) Service Center System Manager (or SCSM). SCSM is mainly geared towards IT service management, so it competes directly with ServiceNow's bread-and-butter. There is also legacy competition from on-site software, notably BMC's Remedy suite. However, ServiceNow has eaten much of BMC's market share over the past 6 years. ServiceNow has raised its market share from 10% in 2011 to over 40% today.

That said, there are fairly low barriers to entry, and many large software companies have entered into portions of it. Some examples here include IBM (IBM) and CA (CA) in IT service management, AppDynamics (owned by Cisco (CSCO) or Splunk (SPLK) in dashboarding, and Zendesk (ZEN) in the customer service vertical... among others.

Despite the competition, ServiceNow's rapid growth, success in up-selling, and incredible customer retention point to a superior product that its customers value. This gives the firm a leg up in winning new business, and we've already established how high switching costs protect those sales against the competition after it is won.

Valuation

Obviously, with a lack of GAAP profits valuing ServiceNow on a P/E (or any earnings) basis doesn't make much sense.

However, I think we can make a few assumptions here. There are a few key factors we can look at: revenue and revenue growth rates (obviously), gross margins, marketing spend, and free cash flow.

Revenue run rate for 2018 is about $2.6 billion, about 34% up on 2017. Analysts generally see about 29% revenue growth for next year, putting us at about $3.34 billion. From there, revenue growth is forecast to continue growing at solid 20-25% annual rates at least for 5 years.

ServiceNow's gross margin is roughly 76%. This sector (business SaaS) generally runs anywhere from 75-85% gross margins, so the company probably has a few points of upside here. Currently, marketing spend is 48% of sales. As we mentioned earlier, this makes sense given the greenfield opportunity, but I believe longer term this settles into more of a 20-25% figure (similar to someone like Cisco or Microsoft). Even at current spend levels, ServiceNow is generating an impressive 25% free cash flow margin. At more nominal marketing spend levels, this could easily reach "Microsoft-ian" levels in the mid-30's.

Given these relatively reasonable assumptions, let's calculate a nominal-spend 2019 free cash flow rate of ($3,340 * 0.30) = $1.0 billion. The firm's $32 billion market cap today would be a clean 32x multiple on that free cash run rate. That's only about 1x the revenue growth rate here - well below the general rule of thumb that an earnings/cash flow multiple should not exceed 2x the growth rate.

So, at the end of the day, a good case can be made that ServiceNow is reasonably priced right now - perhaps even a bit under-priced.

Conclusion and Business Model Diligence Summary

SaaS is an epic shift in the way software is developed and distributed, and those of us that missed the 90's enterprise software boom have another opportunity to catch this wave. ServiceNow looks like an excellent choice within this mega-trend, offering highly recurring and rapidly growing revenues, very sticky product offerings, and even a reasonable valuation.

Check out our "business model diligence" summary below - we think this is unquestionably a "green dot" stock! 

Quick Summary

ServiceNow provides a cloud-based platform-as-a-service (PaaS) designed to automate workflow solutions at large companies. Originally the service was designed to handle the reporting of IT requests and incidents and automate responses by alerting the relevant departments with pertinent information. Over time, the platform has evolved to handle similar workflows for organizational management, security, customer relationship management, and even human resources. ServiceNow has over 4,400 subscribing customers, representing 42% of the world's largest 2000 companies including Netflix, Facebook, and Intel.

Does The Company Have Recurring And/Or Rising Revenues?

YES. ServiceNow's 3-year compound annual revenue growth rate exceeds 35%, and recent results have continued to come in above that level. 92% of revenues are from subscriptions, which are a true recurring source. Despite a large customer base, there is plenty of potential for adding customers, and for extending the platform into new departments of existing customers - 76% already subscribe to multiple products. Management estimates an enormous $60 billion addressable market, against about a $2.6 billion revenue run rate for 2018.

Does The Company Have Durable Competitive Advantages?

YES. ServiceNow has very HIGH SWITCHING COSTS. Request and incident reporting systems are core to the operation of many corporate departments, and once a system has been established, employees trained, and processes in place, there is extremely high inertia against switching systems. This can be seen in ServiceNow's impressive 99% customer retention rate.

Business Model Rating: 

ServiceNow is clearly a GREEN (highly attractive) business model. It has everything we like about the cloud-based enterprise software model: big growth opportunities, recurring revenues, and a highly "sticky" product that protects cash flows for years to come, in both good and bad economic conditions. We see ServiceNow as one of the great enterprise software companies of this generation.